UK equity income: In for the long haul

Much of the interest centres around growth, buying up shares that are undervalued and hoping to make a profit. But at the other end of the scale is equity income investing – buying high-quality stocks that will pay a dividend and produce an income stream.

With bond prices becoming less attractive each day, investors are heading elsewhere in the hunt for income. The UK already has a strong track record of paying dividends and, with some signs that the economy is on the up, investors are looking for ways to tap into potentially increasing income streams.

What’s the appeal?

While bonds have been seen as a safe haven for many throughout the financial crisis, investors are starting to come back to equities, albeit without the confidence seen before 2007/8.

According to Phil Doel, manager of the F&C UK Equity Income fund, the popularity of UK equity income funds is down to a combination of the companies they hold starting to do ‘okay’ and other asset classes looking comparatively expensive.

The past two or three months have seen a move towards ‘bond proxies’, Mr Doel adds – good companies in defensive sectors with low volatility. Companies in the food, tobacco, beverages and household goods sectors with a 4 to 6 per cent top-line growth would fit this category, he says, particularly those with exposure to emerging markets.

Chris Murphy, manager of the Aviva Investors UK Equity Income fund, says “really dull, boring businesses” are good for equity income, such as utilities and coach companies.

“We are very much driven by cash-flow companies as it is cash-flow that pays all the bills,” he says. “It is what, in the end, pays the dividends.”

Choosing a combination of stocks is important as well, he adds. Some companies will be large and sturdy, with a low growth rate, but consistently paying a dividend. Others will have stronger growth and may not immediately pay significant income but hopefully will do so in the future. Mr Murphy cites Majestic Wine as an interesting growth case.

Keeping an eye on the macro factors affecting dividend payouts is also important, he adds. “Different companies have different lifecycles. We have to recognise that you can have companies that can be slightly distressed because of the macro. They might be paying a low dividend but that growth can come back.”

For example, BP struggled in the wake of the Deepwater Horizon oil spill of 2010, paying no dividends for the first three quarters of the year. But its latest dividend has returned to almost three quarters of its payout before the disaster.

Market movements

According to the latest data from the Investment Management Association (IMA), sales in the UK Equity Income sector have been fairly up and down over the past 12 months. In March 2012, a net total of £31m was sold. This shot up to £139m in April 2012 before dropping to a net outflow of £17m in June 2012.

In November, sales hit a high point over the year, totalling £220m, but dropped again to £32m in March this year. The erratic pattern of net sales is shown in Chart 1, although net outflows were only recorded in two months.

The sector’s popularity cannot be disputed. The IMA data, which goes up to March 2013, shows that it holds the second highest total funds under management at £65.3bn, although still a way off the UK All Companies sector, which holds £125.4bn.

It placed 15th out of 35 sectors in terms of net retail sales for March; however, interestingly, it took the top spot for Isa sales at £68.6m, beating the closest competitor – Mixed Investment 20-60% Shares at £40.7m – by a fair margin. Income from funds generated through an Isa is exempt from tax, a likely reason for the sector’s particular popularity here.

Yield and return

It is difficult to directly compare equity income funds. Income is paid at different intervals, be it yearly, monthly or quarterly, and the amount drawn or reinvested will vary between individual investors.

Comparing funds by yield and income reinvested reveals very different results. All results are ranked over 12 months, which is too short term for a thorough assessment but gives an indication of the yearly results if an investor were taking income.

Table 1 lists the top 20 funds in the UK Equity Income sector by yield for the past year, along with yield for each of the past five discrete years. The yield is calculated by data provider Morningstar as the sum of gross dividend rates as a percentage of the bid price. It also shows the 12-month return on £1,000 if the income had been reinvested and if it had not been reinvested, along with the rank relative to the whole sector for each. For accumulation units, Morningstar makes an adjustment to the data to reflect how the fund would have performed had the income not been reinvested automatically.

The best performer in terms of 12-month yield is the Ignis UK Enhanced Income fund at 6.7 per cent for the year to 1 May 2013. Its previous year was also impressive at 7.4 per cent.

Its performance on an initial £1,000 is not so impressive, however. On income reinvested, it produced £1,139, ranking 88th out of 94 funds with 12-month performance. And with income not reinvested, it was 90th, returning just £1,066. This is in keeping with the fund’s stated aim, however, to seek “high income with some long-term capital growth”. Its asset allocation, as at December 2012, is broken down in Chart 2.

Some fund managers are wary of using yield to analyse which equity income fund is best, claiming it can be manipulated. It is possible to artificially make the yield look better by eating into capital, for example, which will lead to worse performance in the long run as the underlying investment is eroded.

A number of funds have produced a top-20 yield in addition to good performance, such as the PFS Chelverton UK Equity Income fund – sixth place for yield at 5.6 per cent and fourth for income reinvested at £1,309 – and the CF Miton UK Multi-cap Income fund, ranked 13th for yield and sixth for income reinvested at £1,287. These show it is possible, at least in the short term, to meet dual long-term objectives of capital growth and income.

Table 2 instead ranks the top 20 by performance with income reinvested. The top performer here is the Schroder Income fund, which has a return of £1,323 on an initial £1,000, and the fund is also second place when income is not reinvested. Across the board, the rankings for income reinvested and income not reinvested are largely similar; the impact of reinvesting income becomes more important with larger amounts over longer time periods.

Equity income funds have been criticised for their income dropping. On average, 12-month yields to 1 May dropped by 59 bp on the previous year, but some experienced far more significant falls. The previously mentioned PFS Chelverton fund, for example, dropped 1.55 percentage points in yield.

Mr Doel argues that dropping yields do not necessarily mean total returns have suffered. “Yields will have dropped because markets have gone up so much,” he says. With that comes an assessment of how the markets will fare in future; Mr Doel says he is looking at a forward yield of 3.7 per cent and a growth rate of 6.7 per cent. Income must grow in real terms to account for inflation, he adds.

How to use equity income

There is some debate around how equity income funds should be used. Some managers pitch them as part of a retirement income strategy, although any retiree using a fund this way would have to be aware of the additional risks of drawing income through equities and its potential volatility. There is also scope for capital erosion, depending on how the fund is being managed.

“Equity income funds are a useful way of getting equity exposure in a diversified portfolio,” says Sheetal Radia, financial adviser at Hertfordshire-based Financial Architecture.

“On the plus side, one would hope that dividends would continue to rise in the future. However, it is important to note that there is no guarantee these dividends will be the same or continue in the future as dividend policy can change. Companies can cut dividends or stop paying them. Hence they should not be used as a way of substituting for the fixed income allocation.”

Jason Hollands, managing director at Bestinvest, says equity income funds can be used for a variety of reasons and that the stocks within make the funds appropriate vehicle for growth as much as income investing.

“We use equity income funds as a key component in most client portfolios, whether they are looking to draw the income or reinvest to compound capital growth,” he says. “Over the long run dividends make up almost half of the return on UK equities, so companies that have a track record of sustaining and growing their payouts are worth taking notice of, especially in the current low-interest-rate environment where yields on bonds are depressed and inflation is higher than the Bank of England’s official target rate.”

The potential for improvement within the UK Equity Income sector is also an appealing factor, along with its capacity for earning outside of the UK.

“Not only are UK dividends attractive compared to bonds, we think there is headroom for further increases as dividends are generally well covered by underlying earnings,” says Mr Hollands. “In fact, corporate payout ratios are approximately 35 per cent of earnings at the moment, which is some way off the 80 per cent peak levels experienced in the mid-1990s.

“Another factor that should support UK dividends is that the majority of earnings for UK-listed companies – around two thirds – are derived outside of the UK. With the pound weakening, this means that when earnings made overseas get translated back into sterling-based dividends, there should be a positive impact.”

Mr Murphy adds that corporate governance puts strength behind UK equity income funds. “Within the UK you have a strong culture of corporate governance compared to many countries,” he says. “That is reflected in a discipline that if companies don’t have the money to spend, they will return it to shareholders in the form of dividends.”

Opportunities elsewhere

The majority of UK investors invest in UK-based funds. Rightly or wrongly, investors are more comfortable with what they perceive to ‘know’. But while UK companies have historically paid out dividends and are likely to continue to do so, there are opportunities in other countries around the globe. Funds with a UK remit may have the flexibility to invest elsewhere in small amounts, depending on their remits.

According to Mr Doel, the prospects for Europe are roughly on a par with the UK. “In Europe, we are looking at about the same yields looking forward, although the confidence in growth rates in Europe will be slightly lower than in the UK,” he says.

The US is also of interest, he adds, with companies in the country getting on board with the idea of dividends. “They seem to have discovered the yield bug,” he says.

Mr Hollands says that the historic reticence of US companies to pay dividends is changing. Last year Apple started paying a dividend for the first time in 17 years, declaring a starting value of $2.65 on 24 July 2012 and most recently at $3.05, declared on 23 April 2013, and there are signs of others following suit.

“The reason this is happening is that many US businesses have a lot of cash on their balance sheets – earning very little income – and so they are more inclined to distribute it to keep shareholders happy,” he says. “As a result, a small number of US equity income funds have started to emerge and we might start to see more launches.”

Asia is also coming on to the radar, he adds, with the increasing number of those paying dividends in emerging markets reflecting improving corporate governance and a shift toward being more shareholder-friendly. “That’s a big shift from the days when many of these businesses still had big family interests on their share registers,” he says.

Uncertain future

The economy is still struggling, although some appetite for risk is clearly returning. But any foray into equities for those seeking a regular income stream should still be treated with caution.

Mr Doel takes a pragmatic approach. At the moment, equities are “dullish”, he says; they are not hugely cheap, but not massively expensive either. Investors should not become complacent just because there are some positive signs. “If things get materially worse, the risk in equities would go back up again,” he says.

According to Mr Murphy, staying in bonds presents a certain type of risk in itself. “What happens if you own a government bond and quantitative easing comes in again?” he says. “At some point they will have a capital loss.”

Interest is undoubtedly gathering around equity income, but whether it is at the expense of fixed-income investing is unclear. “If you can get the same level of income from equities with growth, you have to start considering that as an alternative,” says Mr Doel. “But it is still relatively tentative at the moment.”

Earn one hour CPD points on this article by reading the whole equity income special report.